NetEase: Focusing on Overseas is a Strategically Necessary Choice (2Q22 Conference Call Summary)

Below is the summary of Netease's 2Q22 conference call, for financial report analysis please refer to "Did Netease manipulate its revenue at the beginning of the market? It's really not the result's fault" .

1. Remarks from Management

1.1 Gaming Business

(1) Gaming is still the main source of net profit, contributing RMB 18.1 billion in net profit in Q2, along with other related value-added services. This quarter, we changed our business segment definition to include expanded gaming and related value-added services, including net gaming revenues, as well as gaming-related value-added services such as CC Live, gaming-related accessories, and merchandise.

(2) In Q2, "Fantasy Westward Journey" continued to grow revenue and further shook the entire industry with its strong power and lasting vitality. Our flagship game is still one of the best games on the market today and continues to be attractive to users even after nearly 20 years of operation.

(3) "Diablo Immortal" occupied the top spot on the iOS download charts in multiple regions.

(4) In Q2, "Justice" maintained good user stickiness as we introduced a series of content updates. By the end of May, this game had sold 10 million copies worldwide, making it one of the best-selling PC games in the world.

(5) The game "Endless Lagrange" was ranked first in Q2. Through creative social media marketing initiatives, we greatly expanded the user base of the game, arousing widespread interest among players for our strategic games.

(6) In Q2, we made further progress in globalization by successfully attracting internationally renowned gaming veterans to NetEase. This quarter, we are pleased to announce that Jerry, one of the founders of Xbox Live and one of the main planners of the "Halo" and "Destiny" series of games, will lead our studio in Seattle.

We also welcomed the producers of "Far Cry" and "Assassin's Creed" series to join us and are delighted that he can become the chief producer of our Montreal studio, bringing us more professional knowledge in AAA game production.

In Japan, we are also pleased to welcome senior producer Yuki Kobayashi, who has produced many well-known game series such as "Biohazard" and "Devil May Cry".

1.2 Youdao Education

In terms of education business, Youdao had a total net revenue of RMB 956 million in Q2. Despite challenges during the COVID-19 pandemic and business transformation period, we achieved RMB 104 million in positive operating cash flow this quarter.

In Q2, net revenue from intelligent learning devices was RMB 240 million, a YoY growth of 16%, which indicates that we have maintained resilience despite the impact of the pandemic on the supply chain and logistics. Our flagship products maintained good popularity, and we also launched a variety of new products, covering a wider range of learning scenarios. During the 618 shopping festival on, Youdao Dictionary and Youdao Listening Plan are leading in their respective categories. In July of this year, we launched a new product called Youdao Smart Learning. Our first learning path is equipped with AI diagnostics and adaptive learning functions. This product meets the needs of users to read, listen, write, and practice on a unified device. We continue to provide diversified products in the field of comprehensive education, achieving sustainable growth. In the second quarter, total sales increased more than nine times year-on-year, and more than 180% on a QoQ basis. Looking to the future, Youdao will continue to upgrade diversified products and services to provide Chinese students with more efficient learning experiences. With the promotion of proprietary technology, we are still confident in Youdao's development trajectory in the second half of this year.

3. Cloud Music Business

Regarding cloud music, it is once again facing a more challenging industry environment and macroeconomic headwinds. We maintained strong growth in the second quarter, with total revenue increasing 29% year-on-year to 2.2 billion yuan.

Our membership payment ratio reached 21%, indicating the resilience of our business, and also indicating the high demand of users for cloud music and immersive music experiences. As users are increasingly willing to pay for high-quality content, the number of monthly active users of online music services was 182 million yuan, and the ratio of DAU/MAU remained above 30% during this period.

The gross margin continued to improve, reaching 13% in the second quarter, while it was only 4% in the same period last year. We also launched new high-resolution audio features to provide users with higher audio quality and immerse them in the audio experience.

As of June 30, 2022, Cloud Music has more than 500,000 registered independent artists and has created about 2.3 million songs. In addition, we have also collaborated with top record companies to obtain more top talent content while achieving better commercial terms. In terms of recent authorized content, we have signed multiple authorization agreements with major music companies both domestically and internationally, such as SM Entertainment and YG Entertainment, providing more songs for our users.

4. Yanxuan E-commerce

As for NetEase Yanxuan, in the second quarter, Yanxuan's self-created brand continued to launch popular products loved by consumers across channels. We launched a variety of popular products including handmade vinegar, ergonomic chairs, skin-friendly creations, and Chinese-style fragrances, covering food, home, bedding, personal hygiene, and maternity products.

5. ESG

In June of this year, we released the 2021 ESG report, emphasizing that we have formally established a dedicated sustainable development department and established an ESG committee composed of three independent directors at the board level.

In addition, we are still committed to continuing to develop our carbon strategy and strengthen more transparent information disclosure. In 2021, as part of environmental protection and social causes, we successfully reduced carbon emissions from warehouses, logistics, and packaging sites by more than 3,800 tons, and donated more than 80 million yuan for flood relief and epidemic prevention and control. In addition to continuing to help students in remote and impoverished areas, we have also provided a large number of smart hardware, high-quality courses, and online learning platforms to rural schools. 2. Analyst Q&A

Q: NetEase has been constantly expanding its overseas market and has established several game development companies overseas. What is your view on the future of overseas investment? In addition, can you share what products the overseas studios are currently developing?

A: The overseas market is an important upgrade for NetEase. As we all know, we did not have a domestic game license in the past year. Therefore, we had to make strategic choices and shift our R&D focus to the European, American, Japanese, and Korean markets. Everyone knows that we are very efficient in game production. We are now working closely with many developers to find a product that can be welcomed by global gamers. We do have many products under development. On June 2nd, everyone saw the success of "Diablo Immortal", which I think is an excellent game with a great global response.

Q: In the recent global macroeconomic background, many Internet companies are reducing costs and increasing efficiency. Could the management comment on the outlook for sales and marketing, R&D, and general administrative expenses?

A: We will optimize these expenses, and the optimization process includes both reductions and increased investment. We will continue to look at the problem from a long-term perspective and not make changes just because of short-term macro-environmental factors.

In addition, over the past few years, we have been committed to R&D investment. We have a strong number of employees, and the total number of employees remains relatively stable because we believe that investing in talent and technology is the key capability for creating world-class content.

Q: What is the management's view on the domestic regulatory situation, and what are their expectations for game licenses? In the context of reducing the number of game licenses in the future, what is the strategy for game development? How will they invest in game play and IP?

A: We should focus more on expanding the overseas market and expanding to European, American, Japanese, and Korean users, which is also a warning to us. Because licenses are scarce, we should develop more high-quality games in the Chinese market.

Q: "Endless Lagrange" has been very popular. What are the factors that contribute to the user expansion behind it? How do you view the lifecycle of this type of game in the future? What is the potential for "Eternal Crusade" type mobile games in the long run? How will you form differentiated competitiveness?

A: Our team is very good at presenting operations. "Endless Lagrange" has maintained steady growth in DAU, and the new version we launched in the second quarter of this year has been well received, allowing many players to feel the difference between NetEase's SLG products and other games on the market. Also, we have gained a lot of generalized users, indicating that new products have user penetration.

The reason why "Eternal Crusade" is so successful is that it creates a unique user experience such as battle experience, and users can move freely in the game. Our competitors or other developers cannot create games like "Eternal Crusade" because it requires hardcore and cutting-edge technology. Therefore, we will continue to provide users with a good experience in various ways. Q: Can you analyze the risk of delisting of U.S. ADRs? Can you disclose some information about the listing plan in Hong Kong?

A: Firstly, we are closely monitoring the situation, which is a problem beyond the control of a single company. This is more of a political issue but we remain cautiously optimistic that high-level leaders in the United States and China will find common interests.

Currently, more than 200 Chinese companies are listed in the United States. We really don't think that a hard landing or decoupling will happen, or accelerate. However, in case of such extreme situations, we are actively preparing for it.

We are the second Chinese ADR to be listed in Hong Kong and, although we are currently dual-listed on the Hong Kong Stock Exchange, the conversion from secondary to primary listing is more paperwork, some of which we have been preparing for some time now. If necessary, the conversion will be a very quick and smooth process.

Q: Firstly, regarding the "World of Warcraft" mobile game, there are rumors that the collaboration has been suspended. I just want to confirm if this is an individual event? Or should we be concerned about the company's future relationship with Blizzard, especially after Blizzard's acquisition by Microsoft next year?

A: Our collaboration with Blizzard on "Warcraft" is an independent event and our cooperation is very good. The jointly released game has received wide praise worldwide.

Q: Regarding games such as "Ragnarok M: Eternal Love", have most of the recent incremental users come from the Douyin distribution plan? If so, how should we consider the relevant profit and cost sharing, and will it increase?

A: Regarding your second question on "Ragnarok M: Eternal Love", the answer is that we will continue to monitor and explore effective ways to acquire users, and for certain types of games, Douyin can be a beneficial marketing channel. However, overall, when we focus on the overall profit margin of a game, we consider many factors, including marketing channels and marketing expenses. But I don't think that the success of "Ragnarok M: Eternal Love" depends solely on a single marketing channel.

Q: We see that "Diablo Immortal" has achieved good results. How does management view the performance, performance and lifecycle of this game? What indicators need to be paid attention to?

A: We expect to operate "Diablo Immortal" for a long time, maintaining existing users and, with constant development, attracting more players to experience the game world of "Diablo Immortal".

Q: What are the differences between domestic and overseas games in internationalization and monetization? For example, some American players felt that "Diablo Immortal" was very pay-to-win when it was listed. Will adjustments be made in the future?

A: We do not only serve paying users, but give all users an excellent gaming experience. Many games can be played well without spending money, and we will carry out different development and operations based on the differentiated needs of users in different countries and regions.

Q: How is the performance of "Immortal Legendary" on Xbox, and what is the timetable for launching on PS5 and other devices in the future? How to predict future revenue? **

A: Regarding the performance of "Eternal Abyss", we have disclosed it in the financial report. Since we have joined the Xbox membership mechanism, the game will bring a large number of new users after it goes live. We plan to launch it on PS5 by the end of this year or the beginning of next year, hoping that more players can experience the game.

Risk disclosure and statement in this article: Disclaimer and General Disclosures of Dolphin Analyst